Aaron Drew and Benjamin Hunt The effects of potential output uncertainty on the performance of simple policy rules Aaron Drew and Benjamin Hunt, Economics Department, Reserve Bank of New Zealand In this paper, stochastic simulations of the Reserve Bank of New Zealand’s macroeconom- ic model, FPS, are used to examine the implication of uncertainty about potential output for simple efficient policy rules. Three classes of simple policy rules are examined: stand- ard Taylor rules, forward-looking inflation targeting rules and forward-looking inflation targeting rules that include the contemporaneous output gap. The simulation results suggest that being forward-looking, in terms of inflation, can improve the inflation vari- ability performance of Taylor rules. Looking at it from the other direction, including the contemporaneous output gap in forward-looking inflation targeting rules can improve on their performance in terms of output variability. These basic results are qualitatively robust to constraints on instrument variability and uncertainty about potential. 1.0 Introduction With the achievement of low and relatively stable rates of inflation in many industrialised countries, research has been focused on monetary policy implementation strategies, as summarised by policy rules, that minimise the social loss associated with maintaining these hard-earned gains. This work has generally followed two approaches. The first approach, such as that followed in Svensson (1997), starts from a specification of social preferences and then solves for optimal policy rules conditional on a specific model of the economy. The second approach, such as that followed in Fuhrer (1994) and Black, Macklem and Rose (1997), recognises the difficulty in accurately assessing social preferences and has built on the Taylor (1979) concept of efficient policy rules. Given the model economy, this approach traces out the lowest combinations of inflation and output variance that are achievable by following simple policy rules. The work presented in this paper follows this latter approach and uses stochastic simulations of the Reserve Bank of New Zealand’s Forecasting and Policy System model (FPS) to trace out the efficient policy frontiers associated with three classes of simple policy rules. Although optimal policy rules illustrate the very best that policy can achieve, there are several good reasons for limiting the analysis to simple rules. First, as shown in Clarida, Gali and Gertler (1997), 73 RBNZ: Monetary Policy under uncertainty workshop simple rules tend to describe the historical behaviour of monetary authorities quite well. Second, simple rules like those tested in Svensson and Rudebusch (1998) also come very close to achieving the same outcomes as optimal rules. Third, optimal policy rules are generally very complex and as a result they do not offer a convenient framework for communicating the underlying motivation for policy actions to the general public. Finally, as illustrated in Levin, Wieland and Williams (1998), optimal rules will tend to be highly model specific and to the extent that there is considerable uncertainty regarding the true structure of the economy, simple rules may be more robust. The inflation and output stabilisation properties of three classes of simple rules are examined. The first class is inflation-forecast-based rules (IFB). This class of rule is currently used by several inflation targeting central banks in their economic forecasting and policy analysis models. The second is the standard Taylor (1993) type rule which has gained considerable use throughout the literature be- cause of its ability to describe the historical policy actions of central banks. The third class, a hybrid between the two, is inflation-forecast-based rules with the addition of the contemporaneous out- put gap (IFB+G). The motivation for including the contemporaneous output gap in an IFB rule comes from the efficacy of Taylor rules at explaining historical behaviour and from research on optimal policy rules. The latter suggests that state variables rather than goal variables should enter policy rules. Examining IFB+G rules test whether IFB rules effectively summarise all the information contained in state variables. One argument advanced in favour of Taylor rules is that they are operationally superior in the sense that they can be specified in terms of currently observable data. IFB rules, on the other hand, require the policy maker to formulate forecasts of inflation in a very uncertain world. The results in Black, Macklem and Rose (1997) suggest that under shock uncertainty, IFB rules appear to perform slightly better than Taylor rules. However, this considers only one dimension of the uncertainty that policy makers face when formulating forecasts of inflation. Uncertainty about both the struc- ture and the current state of the economy are two additional dimensions of the uncertainty that policymakers must operate under. In addition to comparing the output and inflation stabilisation properties of the three classes of rules considered, the analysis presented in this paper also exam- ines the implications of uncertainty about the current state of the economy’s supply capacity. Estimating the unobservable level of the economy’s supply capacity is of critical importance for inflation targeting central banks. Whether central banks follow Taylor type rules or IFB rules, an estimate of the current level of potential output will have a significant impact on current policy settings. The implications of uncertainty about potential output for policy rules have been recently examined in Isard et al (1998), Smets (1998) and Wieland (1998). The dimension of uncertainty about the economy’s supply capacity examined here most closely parallels that considered in Issard et al. It reflects the fact that policy maker’s estimates of the economy’s supply capacity will have ex post serial correlated errors that arise due to the characteristics of the unobserved components modelling techniques most often employed. The results indicate that the hybrid IFB+G rules deliver the lowest achievable combinations of infla- tion and output variability. Starting from the perspective of the standard Taylor rule, inflation variability can be improved upon by making the inflation argument forward looking. From the perspective of the IFB rule, adding the contemporaneous output gap improves the output variabil- 74 Aaron Drew and Benjamin Hunt ity performance. These results are robust under reasonable constraints on instrument variability and under uncertainty about the current level of the economy’s supply capacity. The remainder of the paper is structured as follows. In section 2, a brief overview of the structure of the FPS model is presented along with the methodology for generating the stochastic disturbances. Efficient policy frontiers under certainty about potential output are presented in section 3. The implications of uncertainty about potential output on these frontiers are examined in section 4. Section 5 contains a brief summary and conclusion. 2.0 FPS at a glance1 The Forecasting and Policy System (FPS) model describes the interaction of five economic agents: households, firms, government, a foreign sector, and the monetary authority. The model has a two-tiered structure. The first tier is an underlying steady-state structure that determines the long- run equilibrium to which the model will converge. The second tier is the dynamic adjustment structure that traces out how the economy converges towards that long-run equilibrium. The long-run equilibrium is characterised by a neoclassical balanced growth path. Along that growth path, consumers maximise utility, firms maximise profits and government achieves exoge- nously-specified targets for debt and expenditures. The foreign sector trades in goods and assets with the domestic economy. Taken together, the actions of these agents determine expenditure flows that support a set of stock equilibrium conditions that underlie the balanced growth path. The dynamic adjustment process overlaid on the equilibrium structure embodies both “expecta- tional” and “intrinsic” dynamics. Expectational dynamics arise through the interaction of exogenous disturbances, policy actions and private agents’ expectations. Policy actions are introduced to re- anchor expectations when exogenous disturbances move the economy away from equilibrium. Because policy actions do not immediately re-anchor private expectations, real variables in the economy must follow disequilibrium paths until expectations return to equilibrium. To capture this notion, expectations are modelled as a linear combination of a backward-looking autoregressive process and a forward-looking model-consistent process. Intrinsic dynamics arise because adjust- ment is costly. The costs of adjustment are modelled using a polynomial (up to fourth order) adjustment cost framework (see Tinsley (1993)). In addition to expectational and intrinsic dynam- ics, the behaviour of both the monetary and fiscal authorities also contributes to the overall dynamic adjustment process. On the supply side, FPS is a single good model. That single good is differentiated in its use by a system of relative prices. Overlaid on this system of relative prices is an inflation process. While inflation can potentially arise from many sources in the model, it is fundamentally the difference between the economy’s supply capacity and the demand for goods and services that determines inflation in domestic goods